On first
meeting him I wouldn’t have noticed that anything was amiss. As he described his history of trading – his
glory days over the past decade -- his voice
rose to a boom and he paced the room animatedly. When I tried to cut in, he wouldn’t have
it. He was dominating the conversation…until
he began to describe the present day, and then he deflated back into his chair.

He told me, “When
I trade at my best I’m aggressive and
decisive. Ready for whatever the
market throws at me.”

“And how have
you been trading lately?” I asked.

“I’m none of
those. I’m indecisive and cautious. I’m just sort of limp when I need to be
strong and fast. And I just keep losing
money. You know, it’s as if I’ve lost my
mojo.”

Trader Mojo

Mojo. Immortalized for a generation by Austin
Powers, mojo is manliness. Without mojo
there is no vigor, no sex drive, no aggressiveness. Losing mojo is like losing the animating
man-force. When Austin Powers lost his mojo,
he spent most of a movie trying to get it back.

The trader I
was working with had symptoms of low mojo, and they mirror the symptoms of low testosterone – less aggressiveness,
indecisiveness, cautiousness. And there
were a number of recent events in his life that are known to lower
testosterone: a new baby with sleep disruption, co-sleeping with his baby at night, no longer exercising, and even becoming a vegetarian.

Was low testosterone turning this former
shark into a wet noodle?

This week’s letter
will discuss the role of testosterone
in financial decision making, particularly in short-term trading. Along with the testosterone theme, we examine
Anger as a (inverse) predictive signal for future market prices. In next week’s letter we’ll
examine the role of gender and gender-specific hormones in financial decision
making and national economic policy (yes, it appears the fiscal cliff is the fault of men, but more on that next week).

‘Roid Rage

From sensational stories of “roid
rage” among body-builders in the 1980s to thisfascinating podcastproduced by This American Life, which
discusses the role of testosterone in changing everyday feelings and behavior,
testosterone has been long part of public discourse.

Testosterone
level are fixed over the lives of men.
In fact, they rise and fall in response to life events, altering our
moods and behavior in the process.
Testosterone levels decline an average of 1% per year in men after the
age of 30. But even more dramatic, baseline
testosterone falls a median of 30% after men have young children. It falls further when men sleep on the same
surface/bed as their children (co-sleeping) and when they spend more time
parenting. According to a study described here, sleep loss also reduces men’s
testosterone levels. As a result, new
fathers over the age of 30 are likely to experience plummeting testosterone
levels, just when they need extra assertiveness and vigor to advance their
careers.

Body-builders
have long had a sub-culture oriented around testosterone and androgenic
(virilizing) hormone use. For all
competitive athletes, an extra 1% performance boost from testosterone can be
the difference between first place and mediocrity -- just ask Lance Armstrong, Floyd Landis, or the
East German Olympic team. Here is an image outlining the effects of testosterone on
the body. Yet testosterone cannot be easily replaced
with supplements or “boosts” without significant side effects when taken over
physiological norms, as described in thisMayo Clinic article.
Men who take testosterone supplements may not feel the mental and
physical benefits are a worthy trade-off for enlarged breasts and shrunken testicles.

Beyond
athletics, testosterone does significantly influence financial decision making
as well. John Coates, Ph.D. has collected evidence that
testosterone level is not only correlated with, but is also predictiveof, improved financial decision making among ultra-short term
traders.

Investor Anger and
Market Returns

Before we
jump into examining the effects of testosterone on trader behavior, let’s look
at an emotion that is often correlated with testosterone usage: self-righteous anger.

You’ve
probably noticed that a high proportion of comments posted on social media
sites are, well, impolite. In fact, we’ve found enough naked hostility
and open contempt in financial social media commentary to begin quantifying both
Anger and Insults. Our goal was to see
if such combative comments were correlated with future stock returns in the
equities about which such contempt was expressed.

There are a
few compelling examples of anger, like this graph of Netflix (NFLX) which
broadly shows rising anger correlated
with the share price decline, where Anger is the green line and the
candlesticks represent NFLX stock price.

But the
question remains, is rising anger also predictive
of a falling stock price?

To answer
that question, we performed an unscientific study in which we looked at 40 ETFs
tracking the largest indexes, sectors, and industries in North America with
high Buzz (lots of chatter) in financial social media over the past 14 years
(1998-2012). We then sorted those ETFs
by the percentage of that chatter that was Angry
in the Thomson Reuters MarketPsych Indices.
The past 24 hours of Anger aggregated to 30 minutes before the close today
(t) was matched to the percent return from today’s Close to tomorrow’s Close
(t+1). For each Quintile of Angry days -
Angriest 20% of days is on top and least Angry 20% is on the bottom – we
averaged the one-day return of that ETF over the following day. The sample
included data from 1998-2012 but largely centered on 2008-2012 due to a higher
number of ETFs being available for analysis over that period.

One Day Forward ETF
Return

Quintiles

-0.01%

Highest Anger

-0.02%

0.03%

Middle Quintile

0.06%

0.10%

Lowest Anger

Assuming that you are short the ETFs with high anger and long the ones with low
anger, then you may have an interesting strategy. 0.10% (10 bps) per day doesn’t sounds like
much, but over a year that’s a 25% return (excluding transaction costs).

Now keep in
mind that there are a number of problems with this 5 minute study: no transaction costs were included, no
portfolio construction was done, it included ETF’s depending on the overall
Buzz level (a minimum of 2,000), it is not cross-sectional, there are it is not
controlled for price momentum or other condition, etc...

Despite those
caveats, it makes one wonder. Does Anger predictably affect investors’
risk tolerance such that they will not take risk (invest) going forward,
and thus prices are more likely to drop until their anger is worked out? It’s worth investigating…

Anger isn’t
directly related to testosterone, except in that the tendency to take revenge
is in fact modulated by testosterone level.
And it’s not just revenge that increases with testosterone level – many
other behaviors are also impacted by testosterone.

Effects of
Testosterone On Behavior

John Coates’
testosterone research on traders is summarized in this terrific 2010 academic review and in this fascinating 2012 book: “The Hour Between Dog and Wolf.”
Coates holds a PhD in economics and a PhD in neuroscience. But more
importantly, he also worked as a Wall Street trader for many years. Coates began learning about the endocrine
system while still on Wall Street, and in his book he lays out an argument that
the boom-bust cycle in financial
markets may be magnified by hormones
and their effect on behavior.

Endocrinologists
have found that many environmental influences alter human hormone levels and
behavior. For example, before any
competition testosterone levels rise.
Then after the event the testosterone level of the winner rises further and
that of the loser drops. The winner moves
on to the next competition with a now-higher baseline testosterone level, is
likely to act more aggressively, and is more likely to win. Interestingly, Coates and his colleagues
report that, “one trader, who enjoyed a 5-day winning streak during which he
made over twice his daily average P&L, experienced a 75 per cent increase
in mean daily testosterone.”

High
testosterone levels have been found by researchers to increase cognitive skills
such as vigilance, scanning, speed of reactions, and search persistence. And high testosterone improves focus of visual
attention while decreasing distractability.
Further, studies some studies have found that testosterone level is correlated
with risky behavior, sensation seeking, and vengeful behavior. In some other studies, administered
testosterone increases confidence and fearlessness in the face of novelty.

Based on the
evidence, it would make sense that testosterone levels predict performance in rapid-fire trading.

Researcher’s
Corner: John Coates

In one study Coates sampled testosterone from 17
young male traders twice a day over a period of eight business days. The results were impressive: “[O]n days of high morning testosterone, the
traders returned an afternoon profit … that was almost a full standard deviation higher than on ‘low-testosterone’ days.
Interestingly, this relationship was even stronger among experienced traders …,
i.e. those who had traded for longer than 2 years, suggesting that
testosterone, at moderate levels, was not having its effect by encouraging overly
risky behaviour but was instead optimizing performance, at least with respect
to high-frequency trading.” See this visualization of the difference between high and
low testosterone trader performance.

In another study
Coates examined the 2D:4D ratios in 44 traders.
The 2D:4D ratio is the length of the second digit (index finger) divided
by the length of the fourth digit (ring finger). See how it is measured below:

Prenatal
exposure to testosterone influences both ring finger length and also brain
structures related to risk-taking and behavior.
Coates and his colleagues found that the 2D:4D ratio “predicted both the
traders’ P&Ls over a 20-month period and the number of years they had
survived in the business. It also predicted, in line with the
organizational/activational model, the sensitivity of the trading performance
of the original 14 traders [who participated in the first study cited] to
increases in circulating testosterone: the lower the trader's 2D:4D, the more
money he made when his testosterone levels rose.”

Having high
testosterone levels or a high D2:D4 ratio comes with some baggage, as the ratio
is also correlated with infidelity. Case
in point:

Coates summarizes
his research findings as, “[O]ur results suggest that higher levels of
circulating testosterone predict short-term profitability and higher levels of
pre-natal testosterone predict long-term profitability, at least in the segment
of the market inhabited by high-frequency traders.” As Coates notes, these results are valid for
short term traders, but not necessarily for longer-term analysts or
investors.

It’s not
clear that long-lasting elevations in testosterone, such as during a winning
streak are good for traders. It’s likely
that traders, like dominant animals in the wild, will become overextended as
they win. Male animals who defeat rivals
and thus control more territory experience a downside to their success. Ultimately these alpha males suffer more
injuries and have a shorter overall life-span.
Live by the sword, die by the sword.

It is quite
possible that traders who are successful serially and who have higher
testosterone levels will begin to feel fearless
and become sloppy with their risk
management. Testosterone facilitates
sensitivity to dopamine secretion in the brain’s reward system – specifically
in the nucleus accumbens. As a result,
higher testosterone levels are likely to lead to increased risk taking –
pushing the envelope. That is good until
it goes too far and a major loss ensues.
This is the contribution of testosterone to the boom-bust cycle that
John Coates hypothesizes.

DHEA and HGH

Because testosterone itself provokes
a range of adverse effects when taken above physiologic norms, researchers have
studied sex hormone precursors such as DHEA to see if supplementation with this
substance will increase testosterone availability more naturally. DHEA is a precursor of testosterone that was
long thought to improve cognitive functioning and stress resistance. Unfortunately for those seeking a
testosterone-boosting short-cut, in fact studies have not borne out that there
are any psychological benefits of DHEA (see this review and this study of military trainees).

The following image of the body’s
manufacturing pathway from cholesterol to testosterone is from
medicalinsider.com (here). As you can see in the image, increasing
testosterone by augmenting its precursors may also leads to higher levels of
associated hormones such as Estrogen.

Most traders are probably not
looking for increased estrogen.

Other hormones such as Human
Growth Hormone (HGH), famously taken by many ofHollywood’s over-50 elite, do not
increase testosterone levels. And while
HGH appears to have a number of beneficial effects on physique, mood, and
well-being, the long-term effects of use are not yet clear.

As of yet there is no wonder-pill
to increase trading or investment prowess.
Which brings us to natural remedies for keeping our bodies and hormonal
systems healthy.

Like Dr. Evil
and Austin Powers’ mojo, traders who take testosterone aren’t necessarily going
to see benefits from the hormone. There
are significant side effects, and traders should speak with a physician is they
suspect something is wrong.

In my work as
a coach, I find that the best approaches for boosting testosterone in traders are
natural means:
1. Get a good night’s sleep (7-8.5
hours),
2. Get regular and vigorous exercise,
3. Eat foods that raise testosterone,
4. Don’t nap/sleep near your infant
children,
5. Exercise vigorously. Exercise is even better for boosting
testosterone when it is competitive and you win. But beware when a favorite sports team loses,
that loss will literally drop your testosterone levels further.

In our personality research, we see that women and men have similar performance
as short-term traders, but in longer term investing, women have far better performance than men. So while testosterone may benefit men in
short-term trading, where decisions must be made rapidly and aggressively, for
longer term strategic decision making it is unclear that testosterone offers an
advantage. In fact, in our personality
data, we see that men are much more likely to make testosterone-fueled errors
characteristic of “seeking pride” (selling
winners too soon) and revenge investing
to “get back” what the market took away.
These biases are unique to men and significantly erode their long-term
investment performance.

Next week’s newsletter will look at gender
differences between men and women in financial decision making, how the
differences manifest, and how to improve our own gender-biased behavior. The research may surprise you…

Hosuekeeping and
Closing

We recently launched
the Thomson Reuters MarketPsych Indices for monitoring market psychology for 30
currencies, 50 commodities, 120 countries, and 40 equity sectors and industries
in social and news media. In subsequent weeks we’re going to
have interesting charts related to global macro sentiment trends as our new
data is plugged into our internal visualization software.